Monday, March 28, 2011

Northern Oil has its defenders and the defenders tend to point to one thing only – the value of Northern Oil's acreage. After all you would never buy Northern Oil based on its current revenue or its current profit. Here are the quarterly numbers (you will need to click for full detail):

(The company notes the 3c per share loss in the fourth quarter was after oil hedging losses. The loss was also after an extra depletion charge.)

Anyway its pretty hard to justify Northern Oils $1.6 billion market cap based on these quarterly numbers. We are talking approximately 35 times revenue – and well over 100 times earnings (on their numbers – numbers which I believe are inflated).

To justify the market cap you need to assume that soon-to-be-developed acreage is worth a fortune. And the defenders do just that. For example Canacord Genuity (a major promoter) in its daily note (23 March 2011) led with this:

Investment recommendation

We are reiterating our BUY rating and thesis based on Northern Oil’s acreage quality and relative growth potential. The company's core competency is lease acquisition, and we remain encouraged by its ability to accelerate acreage acquisition and development activities. In our view, the recent bearish sentiment and associated sell-off are overdone. We remain very comfortable with our assessment of the Bakken, oil and gas accounting and Northern Oil’s valuation. We view this weakness as a buying opportunity given precedent transactions and the company’s proven ability to organically acquire acreage at accretive levels.

Investment highlights

From our constructive stance, we believe the bulls would argue that Northern Oil trades at a ~17% discount (EV/EBITDAX) to its closest peers (BEXP and OAS) and that the recent Linn Energy transaction (CXO/LINE valued at +$12,700 per acre, NOG valued at ~$8,600 per acre) more than underpins its fundamental valuation. The LINE and NOG metrics are adjusted for production at $100,000 per boepd. The bears point to depletion accounting and corporate governance concerns. While oil and gas accounting is complex, we are very comfortable with our assessment of Northern’s business model, reserve accounting and oversight controls and balances.

The key here – which I highlighted – is that the company is only valued at $8,600 per acre compared to some recent transactions at $12.600 per acre.

That would be good if we were comparing apples with apples (or acres of identical quality). We can however find a good scatter of acreage prices. The Feburary 25 edition of Rocky Mountain Oil Journal gives a Bakken state of play. This is what they said about North Dakota auctions by the State in 2011:

Aside from the oil and gas numbers, North Dakota also set numerous lease records for 2010. The state held four land sales during the year, selling 164,848.38 acres for a total of $311,238,786.60. This translates into an eye-popping per-acre average of $1,888.03. The Mar. 10, 2010 sale was particularly memorable, with 53,274.97 acres being sold for $158,099,211.75, representing an unbelievable per-acre average of $2,967.60.

Note that a $1,888 average is “eye popping” in a trade magazine. The March auction was “ unbelievable” at $2,967.

I run out of adjectives for Northern Oil's market cap at $8,600 an acre. But that is Wall Street – buy it at sub $3000 an acre, put it in a company and have pension funds buy it from you (when you sell your stock) at $8,600 an acre. Everyone is happy!

But hey – why use average auctions when we have Northern's own numbers? When you read these numbers remember that well spacing is typically about 1 per 600 acres to 1 per thousand acres with the lesser spacing being more common. Quoted from the 10K:

The following describes some of our larger acquisitions during the fourth quarter of 2010:

Williams and McKenzie Acreage Acquisition

In December of 2010 we acquired approximately 1,748 net acres for $2,500 per net acre in Williams and McKenzie Counties of North Dakota. All of the acreage consists of non-operated tracts that are not subject to specific exploration or development agreements. Several operators have been permitting and drilling wells in close proximity to the acreage, and we expect development of our acreage will commence in 2011.

Slawson Exploration Lambert Prospect

In December of 2010 we acquired a 50% working interest in approximately 14,538 net acres for total consideration of $1,737,483 in Richland County, Montana. Slawson will be operating the prospect and all drilling and future acquisition costs will be shared pro-rata with Slawson based upon our proportionate working interest in the prospect. This prospect is in close vicinity of Elm Coulee, and considered an extension of the Southwest Big Sky project, which is also operated by Slawson.

BLM Sale

In December of 2010 we purchased 720 net acres from the Bureau of Land Management for $875 per net acre in Richland County, Montana. The acreage lies within a selected township that recently experienced a successful test well targeting the Bakken formation, but is not subject to specific exploration or development agreements.

Miscellaneous Acreage Acquisitions

In November 2010 we purchased 506 net acres for $2,000 per net acre in a single spacing unit in McKenzie County, North Dakota. In December 2010 we purchased 506 net acres for $1,500 per net acre in a separate spacing unit in Richland County, Montana. As of December 31, 2010, the McKenzie County, North Dakota well was awaiting completion and the Richland County, Montana well was spud. In December of 2010 we purchased 322 net acres for $1,775 per net acre in Mountrail County, North Dakota, of which 235 net acres is estimated to spud during the first quarter of 2011.

Now the first acquisition (William McKenzie) is 1748 acres (two or three wells at standard spacing) at $2500 per acre. These will be drilled this year - and they were purchased at about the mid-price for Bureau of Lands sales in 2010. You would expect them to be ordinary acres. It is a bit adventurous the the stock market to value this at $8600 per acre but it is at least in line with industry norms.

But the second acquisition (Slawson Exploration Lambert Prospect) was very different. It was a 50 percent interest in net 14,538 acres (call it 7269 acres net for Northern) for $1,737,483. That is $239 an acre. And they did not buy it from a dupe part - they bought it from Slawson who operates and will continue to operate those acres. The operator was willing to sell these acres for $237. It looks awful rich to value them at $8,600 per acre for these acres.

The BLM sale was at about a third the cost of the average BLM sale during the year - and that was at a competitive auction. $875 per acre in a competitive auction is not chump-change but it is about 10 percent of the market-cap per acre the company trades at.

Wall Street - the capitalization machine

Wall Street capitalizes future earnings. The price of a stock now is the market estimate of what cash it can generate for investors in the future. Sometimes Wall Street is really dismal and the price of stocks is much lower than the value of the same businesses would sell for in a private transaction. (That is when Warren Buffett likes to buy stocks.) Sometimes Wall Street values stocks far more than independent industry transactions. At that time businesses wanting to sell rush go to public.

Boone Pickens when he purchased oil stocks famously said that it was cheaper then to "drill for oil on the floor of the New York Stock Exchange" than it was to drill out in the field.

Northern Oil stock is the anti-Boone-Pickens transaction. The company buys acreage at as low as $237 an acre and have the AMEX value it it at $8600 and have lots of Wall Street's Finest Analysts tell you that is cheap compared to comparable transactions.

I don't know about this one. It's a bit of a turd, but I can see it running for some time yet. Really seems like it's the kind of stock you might use in a pair trade v. WLL or BEXP or one of NOG's other peers.

(Disclosure: bought deep ITM puts when your first post was up, but have since bought offsetting stock, which I'll sell if I want to be net short this name again.)

It would be a real blow to the NOG short thesis if there were deals out there paying huge dollars for undeveloped acreage, so I was very interested to see the Canacord Genuity note which claimed that the CXO/LINE transaction valued acreage at $12,700 per acre.

Maybe Canacord Genuity is just a lot smarter than me, but I can’t figure out how they calculated the per acre valuation.

After looking at the LINE press release on the deal and the CXO 10K, it appears to me that LINE bought working interest and acreage that had 1,350 BOE/d of existing production and 8 million barrels of proved reserves, in addition to some undeveloped acreage for $196 million. The proved reserves had a PV-10 of $131 million at 12/31. With substantially higher oil prices, the PV-10 of the proved reserves would have been over $200 million at the time of the deal.

It appears to me that basically all of the purchase price in the CXO/LINE deal went towards buying the proved reserves and they didn’t pay much of anything for the undeveloped acreage.

That would certainly be consistent with my experience in the industry where we would pay up for proved producing reserves, we would pay a lot less for reserves behind pipe, we would only pay a little for PUDs, and only pennies for probable and possible reserves. Then again, I have been out of the industry for a number of years, and maybe they do things differently now.

John, what is your preferred shorting strategy when confronted with a good short like NOG that has absurd stock borrow rates > 50% annual interest rate? Do you prefer to short the stock and pay the high borrow fees, or do you prefer a hybrid strategy like going short a very in-the-money call option?

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.